Enlightening theConstitutional

Debate The tenth in a series of discussion events to enlighten the

public debate on Scotland’s constitutional future.

Currency, Banking and Taxation20 January 2014 at the Royal Society of Edinburgh

IntroductionThe public discussion on Currency, Banking and Taxation was an additional event in the series, and aimed to promote discussion of the issues covered in two earlier events in the series, both of which were held at the British Academy in London. The speakers at this event were invited to discuss questions concerning banking and financial services, the currency options that would be available to an independent Scotland, the implications for fiscal rules and financial regulations, and the implications for taxation and public expenditure.

Chair:• Ms Sarah Smith, Newscaster, Channel 4 News

Speakers:• Professor John Kay CBE, FBA, FRSE, Economist;

• Dr Angus Armstrong, Director of Macroeconomic Research, National Institute of Economic and Social Research;

• Ms Jo Armstrong, Independent Economist; and

• Professor Gavin McCrone CB FRSE, Former Chief Economic Adviser, Scottish Office.

The Chair, Sarah Smith, opened the discussion by observing that the debate about currency, banking and taxation in an independent Scotland is a highly important topic. She acknowledged that the Scottish Government’s expressed preference is for an independent Scotland to continue using the pound as part of a currency union, and referred to a speech by Mark Carney, earlier that day, in which he discussed just how much that option might limit Scotland’s fiscal autonomy. Ms Smith suggested that the evening’s discussion would look at the types of constraints that might be applied by the Bank of England, to an independent Scotland, in return for a formal monetary union. Speakers would also discuss the alternative currency options held by an independent Scotland, as well as looking at questions about banking and financial services, which are so closely linked with currency. Additionally, she suggested that questions around taxation and public spending would also be examined. Ms Smith then introduced the panel of speakers, and welcomed the first speaker, Professor John Kay, to the platform.

Professor John Kay, Economist.

Professor John Kay compared the circumstances of Ireland’ssecession from the UK with the current debate around Scotland’s options post-2014, observing that when Irelandbecame independent in 1922, nothing happened in economic terms; the debate in Ireland was not about economics. After independence, people carried on usingBank of England notes as always. It was not until 1927 thatIreland first issued its own bank notes, and not until WorldWar Two that it established its own central bank. It was 1979before Ireland broke the link with sterling. Professor Kay

suggested that things could not proceed at so leisurely a pace today. To demonstrate this point, Professor Kay referred to the most recent analogous case, the break up of the former Czechoslovakia. In this instance, the assumption was made that the break up could take place and the currency could be sorted out at a later date. Thisarrangement lasted only three weeks, when it was decidedthat there would have to be separate currencies for theCzech Republic and Slovakia. The shifting of funds betweenthe two nations was so large, even before the separation,that the attempt to delay this decision proved unsustainable.

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The currency option adopted by an independent Scotlandis therefore extremely important, and a decision on the currency an independent Scotland would choose is thoughtby Professor Kay to be the most urgent decision to be madein the lead up to the Referendum on Scotland’s future. Scotland, he observed, has three main currency options:

1. Scotland could join the Euro: Professor Kay suggested that this is no longer as serious an option as it onceseemed, partly because a newly independent Scotlandwould not meet the Maastricht criteria of debt and deficit. What is more, joining the Euro does not make sense for an independent Scotland, because the rest of the UK is by far Scotland’s largest trading partner. However, an independent Scotland would seek to become a signatoryto the EU treaty, which would entail an obligation to at least express a vague interest in joining the Euro at somepoint down the line.

2. Scotland could establish a monetary union with the rest of the UK: Professor Kay saw this as the most sensiblemonetary union option for an independent Scotland, butpointed out that this would not be straightforward. He observed that a monetary union would be possible only if accompanied by progress towards a fiscal and bankingunion and that this, in turn, raises two problems for an independent Scotland. The first relates to how much autonomy an independent Scotland could expect to haveas part of such a union; the second relates to what theterms of negotiation would look like, given the disparitybetween Scotland and the rest of the UK and the fact that the rest of the UK is ten times the size of Scotland. Professor Kay suggested that whether or not fiscal andbanking union truly is essential to the success of a monetary union, the fact that the perceived wisdom declares that it is defines the negotiating position. On this basis, Professor Kay suggested that Scotland’s negotiating position is weak. He pointed out that it is inconceivable that the rest of the UK would be willing to concede to Scotland.

Another version of monetary union, therefore, is the unilateral option, which would see Scotland retaining sterling but using this unilaterally. Ecuador is an exampleof a country that has followed this option – both Ecuadorand Panama use the US dollar unilaterally, and Montenegrouses the Euro unilaterally. However, Professor Kay observed that this option can work only for countries that are too small to issue their own currency, or which are soeconomically unstable that they prefer to entrust the administration of their monetary and banking system tothe banks of other countries. Neither of these descriptionswould be relevant to an independent Scotland.

3. Scotland could have its own Scottish currency: Professor Kay suggested that the final option for an independent Scotland would be for it to have its own Scottish currency. This currency could be pegged to the sterling, but the Scottish Government would need some reserves to pegtheir currency in this way. Maintaining parity is a possible option, illustrated by Hong Kong, which has pegged the

Hong Kong dollar to the US dollar. An alternative option is for the Scottish currency to float against the pound. ProfessorKay observed that it would not make sense for the currencyto float very much, given that Scotland exports a largeamount to the UK. An example of a currency which floats inthis way is the Swedish krona, which floats around the Euro.

Having provided a summary of the available options and theadvantages and drawbacks to each, Professor Kay suggestedthat the purpose of the evening would be to debate the meritsof these options. He suggested that in a negotiation with therest of the UK, he would expect that Scotland would fail ingetting all of its preferences met, and would therefore needa plan B to turn to. This plan B would probably be Scotlandhaving its own currency, pegged to the British pound.

Ms Jo Armstrong, Independent Economist

Ms Armstrong proposed to discuss the likely consequencesfor public expenditure of Scotland becoming independent.She suggested that following the Referendum, whether Scotland became independent or adopted devo-max, expenditure and taxation would be issues that needed to be addressed. Ms Armstrong proposed to discuss two or threekey issues relating to expenditure and taxation

She indicated that whatever the outcome of the Referendum,the Scottish Government faces a serious fiscal challenge inthe shape of a fiscal deficit that it will have to close. Currentprojections indicate that Scotland will continue to have adeficit in the short term, so it will need to either erase itsdebt, or raise taxes. Ms Armstrong acknowledged that an independent Scotland would have the option of simplyspending less, for example by reducing spending on defence,but observed that to fill the gap, cuts to spending would haveto be substantial. Scotland’s current spending on defence is£3.3 billion, and the fiscal gap is £7.6 billion, meaning cuts tothe defence budget alone would not fill the fiscal gap. To fillthe gap, Scotland would need to look at cuts to spendingand/or increased borrowing, and/or increased taxation. MsArmstrong observed that the UK is doing this, and is lookingto balance the budget by 2017/18. She pointed out that ifScotland stayed in the Union, it would have to take its shareof the fiscal pain, observing that 50% of the UKs impliedspending cuts are still to come into effect. If Scotland left theUnion, without its Barnett allocation but with the revenuesfrom North Sea Oil, it would need to outline an equally plausiblefiscal plan so that it could continue to borrow, or seek to borrow, additional funds. Ms Armstrong observed that at themoment we have no indication of whether that plan wouldlead to the same level of cuts [as are being made in the UK],higher levels of cuts, or lower levels of cuts. She indicatedthat there is a need for greater clarity around what an independent Scotland’s fiscal austerity plans would look like.

Equally important when considering Scotland’s fiscal outlookis North Sea Oil, and the fact that Scotland’s tax revenues aremore dependent upon oil than are the rest of the UK’s. MsArmstrong indicated that initial projections, even those including a geographic share of North Sea Oil for Scotland,

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show that oil and gas revenues are not sufficient to close the funding gap. Ms Armstrong observed that declining production, coupled with increased operating costs, has ledto a downward projection in North Sea tax receipts. She suggested that if we saw higher oil prices, oil revenues wouldrise, but that the impact would not be a one-way bet, sincehigher oil prices reduce the profitability of non-oil companies. We therefore need to look at the whole pictureof increased oil prices. Ms Armstrong pointed out that NorthSea taxes account for 20% of Scotland’s tax revenues, butonly 2% of the UK’s; meaning variability around figures relating to North Sea Oil revenues has a greater impact onScotland than on the rest of the UK. Ms Armstrong suggestedthat establishing an oil fund might be an option for an independent Scotland, observing that an oil fund would ensure that future generations were able to benefit from depleting resources. However, she pointed out that NorthSea taxes (and more) are currently needed to fund Scotland’sspending plans, so an oil fund would in fact exacerbate thefiscal challenge and make the fiscal gap larger.

In the event of a ‘No’ outcome in the Referendum, Ms Armstrong suggested that there would be a possibility ofdevo-max coming in through the sidelines. She observed that even if there is a ‘No’ vote, following the Referendumthe current Scotland Act still comes into play, which extendsScotland’s powers further. She acknowledged that there appears to be a desire in Scotland for some further extensionof Scotland’s powers, but made the point that Scotland hasnot yet tried and tested all the powers it will have. Thismeans that the infrastructure is not in place for the extension of fiscal powers; for example, there is no revenuefunction, no Treasury, and no debt management office, andall will be needed in an independent Scotland, and even tosome extent when the Scotland Act comes into full force. Onthis basis, Ms Armstrong suggested that there are fiscal risksfor Scotland even without independence. The Scotland Actwill create a Scottish rate of income tax, whereby HM Treasury will reduce income tax at the basic and higher rates[in Scotland] by 10%, and reduce the block grant accordingly,and then allow the Scottish Government to levy a tax to fillthat gap. Stamp-duty land tax will also be replaced, underthe powers of the Scotland Act, with the land and buildingstransaction tax. This is intended to be a more progressive tax.Finally, the new landfill tax will be roughly equivalent to thelandfill tax which exists at the moment. The Scotland Act willalso give Scotland additional borrowing powers, with Scotland able to borrow around 10% of its capital budget. By 2015/16, when these powers come in, that figure is projected to be around £230 million, to be used to fund infrastructure. Scotland will also have a short-term borrowing facility of around £200 million per year, which will allow it to deal with short-term revenue volatility thatmight occur as a result of the new tax-raising powers whichare yet to be tested. Ms Armstrong pointed out that thepowers extended under the Scotland Act are substantiallydifferent from what we currently have, with the status quocompletely gone. Even beyond a ‘No’ vote then, the fiscaloutlook will be different.

Ms Armstrong made the point that economic and fiscal policy that would lead to growth and productivity in Scotlandare essential. She suggested that it is not yet clear how theScottish Government will use its fiscal powers to make thenecessary changes in fiscal productivity. There needs to be an understanding of how the Scottish Government will makethis work. Within the Union, Scotland would continue to receive its block grant; however, there are those who wantto see changes to the Barnett Formula. Ms Armstrong predicted that a ‘No’ vote in the Referendum would see arenegotiation of the settlement Scotland currently receivesfrom Westminster. She observed that whatever the outcomeof the Referendum, uncertainty on fiscal outcomes exists.She concluded by suggesting that these are questions towhich we need answers, in order to get some certainty as to whether the anticipated additional risks of Scotland becoming independent outweigh the anticipated benefits.

Dr Angus Armstrong, Director of Macroeconomic Research,National Institute of Economic and Social Research

Dr Armstrong opened his presentation by observing that inthe Scottish Government’s White Paper on Independence,Alex Salmond has stated that independence is about ‘thepower to build a country which reflects our priorities as a society and our values as a people’1 . Given this understand-ing of what independence means, Dr Armstrong proposed tolook at the question of what kind of currency arrangementan independent Scotland would need in order to match theaspirations of the White Paper. What kind of currencyarrangement would allow these priorities to be expressed?The Scottish Government has made it clear that it wants afull-blown monetary union, and has suggested that this is in the best interests of all sides. Dr Armstrong therefore proposed to begin by providing a definition of what is meantby a monetary union. He indicated that whilst a currencyunion means sharing the same currency, a monetary unionmeans sharing a currency, a payment system, a central bank,and usually bank regulations. It is a formal monetary union,rather than a currency union, that the Scottish Governmentis seeking.

Dr Armstrong therefore asked, what is in a monetary unionfor each side? He observed that each side would benefitfrom the minimum disruption allowed by a monetary union.People in Scotland could continue to receive their pensionsand pay their mortgages in pounds; the Scottish Governmentcould issue debt in a currency recognised and trusted aroundthe world; and there would be no additional costs to tradingbetween Scotland and the rest of the UK. However, Dr Armstrong pointed out that all of this could also be achievedin a currency union. The difference, he observed, is that aformal monetary union comes with an implicit insurance policy that just in case one side of the union gets into financial trouble, the other side may help it out. In the caseof Scotland and the UK, the Bank of England would providethis insurance policy, but UK taxpayers would be the mainunderwriters. So, what would the rest of the UK get in return? Dr Armstrong suggested that a formal monetary

1Scotland’s Future – Your guide to an independent Scotland, November 2013

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union would allow the UK to avoid trade costs when tradingwith Scotland, and to avoid losing oil and gas exports. However, because the rest of the UK is ten times larger thanScotland, it would not get the insurance policy that Scotlandwould be getting. He pointed out that this means an independent Scotland might take more risk, because it hasan insurance policy should this risk taking backfire. The UKwould therefore want to apply fiscal constraints to preventan independent Scotland from taking such risks. He observedthat the more debt Scotland inherits, the higher this risk, andthe tougher the fiscal constraints on an independent Scotland would need to be. Dr Armstrong observed that theWhite Paper on independence sets out the view that in an independent Scotland, it would be open to the people ofScotland to make different fiscal arrangements in the future.In reality, however, if an independent Scotland sought a formal monetary union with the rest of the UK, this is unlikely to be the case.

Given the difficulties of maintaining a formal monetaryunion, Dr Armstrong asked whether such a union would fulfilthe priorities for independence set out by the Scottish Government in the White Paper. He reiterated that with therest of the UK representing 90% of this monetary union, andwith the only prospect of a bailout existing in favour of Scotland, the UK would want to apply strong fiscal constraintsto an independent Scotland. He also observed that the UKcould choose to end this monetary union at any time, whichcould prove quite inconvenient for Scotland. On this basis, hesuggested that rather than a formal monetary union, thebest option for an independent Scotland might in fact be anew Scottish currency. He observed that the Scottish Government’s Fiscal Commission has suggested that the creation of a new Scottish currency would provide an independent Scotland with the greatest opportunity for autonomy. He added that it would be in the interests of therest of the UK to help Scotland to do this, without creatinguncertainty or instability. However, he also pointed out thatin order to achieve this, an independent Scotland would need itsown central bank, its own exchequer, a tax office, a currencyconversion law, a debt management office, an independentfiscal commission, and its own mint. This is a lot to achieve ina year and a half, so the Scottish Government would need tostart preparations for this early, ahead of the Referendum.Once Scotland had its own currency, this could be pegged tosterling and Scotland could choose its own policies, thosethat met the priorities of Scotland and not the rest of the UK.

Professor Gavin McCrone, Former Chief Economic Adviser, Scottish Office

Professor McCrone began by suggesting that there are circumstances in which a small, independent state can do better than as a region of a larger state, but observed thatthere are huge costs associated with the required disentanglement, which have been largely ignored so far. A monetary union with the rest of the UK would minimisesome of these costs, and the Scottish Government does notappear prepared to consider an alternative; it has no plan B.

Referring to Scotland’s financial position, Professor McCronesuggested that although Scotland has a smaller deficit than theUK, both have deficits that are too large to be sustainable.Measures are needed to reduce these deficits. He added thatestimations about Scotland’s fiscal outlook rest on figureswhich are uncertain. For example, the assumption that an independent Scotland would get a 90% share of North Sea Oilrevenues; the assumption that Scotland would take a population share of the national debt; and the assumptionthat if Scotland got 90% of North Sea Oil revenues then GDPwould increase, making Scotland’s share of the debt a smallerproportion of its GDP. A further area of uncertainty is aroundthe rate of interest that an independent Scotland would be expected to pay on its debt. Professor McCrone observed thatScotland would be a new borrower, with no established credibility, and that the UK has never defaulted on its debt,but that this record could not be applied to a newly-independent Scotland. It is likely, therefore, that Scotlandwould pay a higher interest rate on its debt than the rest ofthe UK. What is more, revenues from North Sea Oil are projected to decline which, coupled with Scotland’s ageingpopulation, means that there is an expectation that revenuefor an independent Scotland would be declining while publicspending increased. At the moment, Scotland contributesabout its population share to the national exchequer in taxrevenue, if you exclude North Sea Oil. However, it also has apublic expenditure about 10% higher than that of the UK, sothey don’t balance. The importance of North Sea Oil revenuesis therefore to try and bring them into balance. This is a problem, because if Scotland’s public expenditure continuedto be higher than that of the rest of the UK, then that wouldresult in a deficit. On this basis, Professor McCrone cautionedagainst the assumption that, under independence, everyone in Scotland would be £500 better off, suggesting that people relying on this figure would do better to forget it.

Professor McCrone suggested that an independent Scotlandwould have to be fiscally conservative as a result of having notrack record. This would require it to be very careful with its finances. He observed that, due to quantitative easing in theUK, the Bank of England now owns one third of the UK debt,with the interest paid on this debt going back to the Treasury.He raised the question as to what might happen to that pieceof the debt in the longer term, and queried whether, if the UKGovernment cancelled the debt, that would count as a default.He also queried whether, if an independent Scotland took ashare of the UK debt, Scotland’s portion of this debt would be reduced in the same way.

On the subject of currency, Professor McCrone agreed withProfessor Kay that there are really only two viable options foran independent Scotland; a formal monetary union with therest of the UK, or a separate Scottish currency. He pointed outthat establishing a monetary union depends upon what termscould be agreed and whether Scotland could ensure sufficient independence with regard to its fiscal policy in theevent of a monetary union. The prospect of a monetary unionraises questions. For example, would Scotland have a separatecentral bank? This is a requirement of EU member states, so ispresumably something that an independent Scotland would

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need to set up. A further issue is around debt. Professor McCrone pointed out that an independent Scottish Government would issue its own Government debt, which the UK would not be guaranteeing, meaning the interestrates would be higher. He floated the question of whetherthe rest of the UK would become a lender of last resort foran independent Scotland, and pointed out that Brian Quinn, who has written a paper for the David Hume Institute, andwho is a former Deputy Governor of the Bank of England, sees a great difficulty with this. Finally, he pointed out that if a monetary union were to work, not only would the level of fiscal deficit have to be agreed, but discriminatory taxeswould have to be avoided. This would make it difficult for an independent Scotland to keep corporation tax 3% lower than the rest of the UK, because this would not be acceptable within such a union.

Having a Scottish currency would give Scotland greater flexibility, Professor McCrone suggested, because Scotlandwould have the option of changing the exchange rate in thelong term. However, he suggested that there are problemswith this. Scotland has a large financial sector, with the bulk of its clients based in England. There is, therefore, a dangerthat some institutions would simply move their headquartersinto the rest of the UK if Scotland became independent; for example, life assurance companies. That would apply also tofund managers. Professor McCrone also made the point thatthe structuring of the banks raises a further question. He suggested that Iceland and Ireland both provide examples ofthe dangers faced by a small country that has a bank too bigfor it to cope with. He therefore voiced an expectation that at least the two main Scottish banks, in the event of independence, would be headquartered in England.

Professor McCrone suggested that a further problem withScotland having its own currency is that this would affect existing pensions and mortgages, meaning that people could end up having a mortgage in sterling and the assetin a Scottish currency. This is a risky situation to be in. There would inevitably be a degree of exchange in repayingthe loan; for example, if the Scottish currency fell against the pound. Speaking about pensions, he suggested that some of the same problems would arise. He observed that at the moment, most of the pension companies in the private sector are suffering from a substantial deficit, butthe EU requires pensions that cross national boundaries to be fully funded. This would cause real trouble for a lot of these pension providers, and some of them would have to be wound up if the requirement were interpreted literally. Professor McCrone suggested that this could probably be negotiated with a suitable transition period, but added that it represents another sticking point that creates potential difficulties.

In summary, Professor McCrone suggested that Scotlandwould face a lot of problems in becoming independent. Scotland is a wealthy nation with the resources to be successful, but whether it were or not would greatly depend on the Governments in power at the time.

Questions and Answers

The Chair, Ms Smith opened the Question and Answer session by asking the panel whether they thought it likelythat in the event of Scottish independence, the Bank of England would give lender-of-last-resort facilities.

Professor Kay expressed his uncertainty about what the concept of ‘lender of last resort’ is taken to mean underthese circumstances. He observed that this is not a conceptthat has ever arisen previously, pointing out that a lender oflast resort used to mean that the central bank would step inand lend money at a penal interest rate to solvent bankswhich were suffering from a liquidity crisis. In 2008, lender of last resort appeared to be turned into a description forsomebody who lends money at a concessionary rate to insolvent banks. Professor Kay indicated that he does not understand why anybody would wish to do that. He suggested that in an independent Scotland, the Scottish Government policy should be that if there were insolventbanks in Scotland, then the Scottish Government would seizethe ring-fenced assets of the bank which related to its deposit taking activities in Scotland, pay off depositors whowere resident in Scotland, and not worry about the global creditors of international banks, who would not be the Scottish Government’s or the Scottish tax-payers’ problem.

He indicated that an independent Scotland should seek toavoid the mistakes of the Irish Government, which thought itwas guaranteeing the deposits of Irish depositors, but endedup guaranteeing everything that had ever been lent to anIrish bank. He observed that this liability almost bankruptedIreland, and had this been done in the Scottish case it wouldcertainly have bankrupted Scotland, because the liability ofHBOS and RBS at the time that these banks failed was around13 times Scottish GDP. If the Scottish Government had guaranteed these liabilities, Scotland would have been bust.The implication of the Scottish Government taking the policy suggested is that there would not be any globally-operatingbanks Headquartered in Scotland, for as long as they couldfind other countries to underpin their liabilities.

Responding to this suggestion, Ms Smith asked whether suchan approach would be practical for an independent Scotland.Dr Armstrong responded that the lender of last resort issomething which takes place under the sterling monetaryframework. The Bank of England’s counterparties includeAmerican banks and German banks, and Dr Armstrongsuggested there was no reason to believe this would not include Scottish banks. However, these are subsidiaries whichare regulated in the UK, meaning a lender of last resort shouldand could extend to Scottish banks too, but only if they weresubsidiaries which were regulated in the UK. He added thatthis is intended to be against good collateral. He suggestedthat the question was really around the provision of exceptional liquidity assistance, not really lender-of- last-resort facilities. Responding to the suggestion by ProfessorKay, that Scotland simply adopted a different type of bankingsystem which excluded international banks, Dr Armstrongadded some caveats to that. He first indicated that the sterlingmonetary framework includes not only banks, but also

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financial institutions, pointing out that a very large insurancecompany was also bailed out during the financial crisis. Hetherefore expressed doubt about the idea that this would always apply only to banks. Secondly, he pointed out that anindependent Scotland might have more opportunity to regulatethe banks than it has done as part of the UK, but added thatthere is an apparent political resistance to tougher regulationof the banks, which he stated he did not really understand.He observed that in theory, Scotland could implement thetype of policy described by Professor Kay, but questionedwhether it actually would do it, and whether Scotland wouldbe willing to have no big banks operating within its territory.

Professor Kay suggested that a policy of supporting the banksis observed because of the political power of the financialservices industry. However, Dr Armstrong responded that regardless of the political power of the financial sector, Scotland is a democracy and must, on that basis, have someway of containing the behaviours of the financial sector.

A member of the audience suggested that the UK Governmenthas not been very successful in its monitoring of the Scottishbanks. He asked whether independence for Scotland mightallow the Scottish Government to change this and to create abanking system like that which used to exist – i.e. one whichis very conservative and safe. Taking up this question, MsSmith asked the panel whether the risks taken by Scottishbanks did occur because Scotland was part of the UK. Professor Kay responded that this was not the case, and observed that regulators have not been successful [in regulating banks and financial institutions] anywhere, andare unlikely to be successful in the future. Ms Smithaddressed the same point to Professor McCrone, asking ifthere is any reason to believe that the financial sector wouldbe more safely regulated in an independent Scotland. Professor McCrone responded that it would not be possibleto have huge banks without these risks, and reiterated hisbelief that large banks would be headquartered in the rest of the UK, in the event of Scotland becoming independent.These banks, he suggested, would operate through subsidiaries in Scotland, which would be regulated in Scotlandand whose liabilities would be very much less. Professor McCrone suggested that much of the issue of bank regulationgoes back to the Conservative Government’s ‘big bang’,which freed things up and enabled bank takeovers to occurmuch more easily. He suggested that attempts to take overthe Royal Bank of Scotland had been made before, but hadbeen resisted, and observed that after the ‘big bang’ resistingthese attempts was no longer possible. Discussing the possibility that Scotland’s big banks would headquarter inEngland in the event of Scotland becoming independent, MsSmith asked how dangerous it would be for Scotland to losethat part of its financial services sector.

Ms Armstrong pointed out that the information available onthe revenue side is very poor, so it is difficult to tell howmuch corporation tax Scotland currently receives from institutions headquartered here and, therefore, whether an independent Scotland would lose a lot of corporation tax iflarge financial institutions were to headquarter elsewhere.The implication is that this would be the case, but the data

available makes it difficult to know. She suggested that partof the reason that massive losses by the banks can still resultin bankers’ bonuses is that there is still a belief that thebanks will make lots of money in the future. The reality, shepointed out, is that we just don’t know what the banking sector will look like in the future. She observed that if banksare only allowed to grow to the deposit size available withinthe country, this limits the size of the banks that Scotland canhave, and probably also limits the number of banks it canhave. She suggested that the question to ask is what sort ofbanking sector we need to support business, not what sort of banking sector we need to try to make huge profits.

A member of the audience asked the panel to clarify whetherScottish GDP includes the earnings of Scottish banks madeanywhere, or just the revenues that have been raised in Scotland. The question was posed as to whether the ScottishGovernment could offer to transfer bank headquarters out ofScotland to reduce its GDP when entering into negotiationswith the UK Treasury. Professor McCrone clarified that Scottish GDP includes the earnings of all people working inbanks in Scotland. On this basis, he suggested, it would beeasy for a Scottish bank to move its profits elsewhere. However, he observed that what is in Scottish GDP figures for the profits of companies is only an estimate, and that if Scotland became independent a lot of companies mightbegin declaring their profits in England. On the other hand, if Scotland could get away with charging a lower corporationtax than the rest of the UK, there might suddenly be a lot ofbusinesses who would wish to declare their profits in Scotland.Professor Kay added that the inclusion of North Sea Oil inScottish GDP greatly exaggerates how rich Scotland is, because much of the revenue from North Sea Oil is earnedby international oil companies and never comes near Scotland. Another example of this is Scotch whisky, a lot ofthe profits of which are apparently earned in the Netherlands.

A member of the audience asked the panel how Scotlandshould move forward in the event of a ‘No’ vote in the Referendum. Referring to the Barnett Formula, he asked howScotland could ensure that it kept its share of expenditurehigher than the rest of the UK, on the basis of Scotland paying in high oil tax revenues, whilst also ensuring that theblock grant was distributed to the regions on the basis ofneed rather than by head of population. Ms Armstrongresponded that the Barnett Formula is a political fix which isnot based on need, and observed that the Welsh Assemblyhave undertaken a piece of work showing that if looked at on a needs basis, Wales is being short-changed by the Barnett Formula. She pointed out that there are always opportunities to change the current Formula arrangement, and acknowledged that it is definitely up for change, but that the outcome of any changes would be as a result of negotiation. On the assumption that Scotland should getmore than the other regions under this arrangement becauseit puts in more, she pointed out that this has only been thecase since 1980, when North Sea taxes started.

A member of the audience asked Professor McCrone about areport he had written in 1974, which suggested that Scotlandwould be as rich as Switzerland if it used its oil revenues. The

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audience member suggested that this report had been ‘suppressed’ for over 30 years, and wanted to know why. He also commented upon the fact that in discussing tax, nomention had been made of the value of avoided and evadedtax. Referring to the paper, Professor McCrone respondedthat this had been written when he was a civil servant as abrief in the period before an election, and had indicated thatNorth Sea Oil revenues in the 1980s would be larger than theoutgoing Government had said. The report suggested thatthe Treasury of the outgoing Government had grossly underestimated the potential value of North Sea Oil for theforthcoming period. Professor McCrone pointed out that this report was a briefing paper written when he was a civil servant. Briefing papers by civil servants are never published.The paper had not been suppressed.

The panel was asked to comment on the perceived future ofScottish bank notes. It was observed that in the White Paperit is suggested that Scottish banks would continue to issuetheir own bank notes, but the point was made that this statement might be one of wishful thinking. It was suggestedthat it would seem strange for the Bank of England to be expected to supervise the circulation of bank notes in a separate country. It was therefore asked whether, with theprospect of independence, the future of Scottish bank notesis under threat. In the event of a monetary union with therest of the UK, would it be Bank of England notes which circulated in an independent Scotland? Dr Armstrongresponded that Scottish bank notes are backed by notes inthe Bank of England, so any new Scottish notes would alsohave to be backed. He suggested that this becomes something like a currency board2 , with the possible paradoxbeing that if the Scottish Government became concernedthey could just replace these notes with English pounds. Professor Kay observed that due to a loophole, Scottishnotes don’t have to be backed seven days per week, so Scottish banks could, in theory, profit by the arrangement.He pointed out that this is plainly an anomaly which causesirritation, but which it has so far been considered unwise todisturb. He suggested that this arrangement would be up forgrabs in any negotiations following independence.

A question was raised as to whether the debate on Scottishcurrency would raise questions about the UK budget and financial stability, because it is the UK which is running adeficit and undergoing quantitative easing. Professor McCroneresponded that in the UK as a whole, things are graduallygetting better. He pointed out that the UK has faced a majorfinancial crisis, and that this wasn’t because of excessive UKGovernment borrowing, but due to over-lending by banks tothe private sector. He suggested that this will take a longtime to unwind. Ms Smith asked Dr Armstrong to commentupon whether the debate being held in Scotland has changedthe way in which the economy as a whole is viewed fromLondon. Dr Armstrong responded that the debate has notyet had real resonance in London, in spite of the fact that the rest of the UK’s debt to GDP would rise by 10% almost immediately upon Scotland becoming independent.

Ms Smith asked the panel to reflect on the quality of the

debate and the information which has been made availableso far, and asked whether there has been enough informationmade available. Ms Armstrong responded that there hasbeen both too much and not enough information, observingthat some of the information made available has been impenetrable and some of it has been completely inaccessible.She pointed out that unless and until we are made aware ofthe realities of what an independent Scotland would looklike, it is not possible to see how this would map againstwhat we could and could not afford to spend on and investin. She suggested that the challenge is to look at the uncer-tainties presented by both positions, adding that transitioncosts in an independent Scotland could lead to capital flight.She asked the question, is it worth the pain [for Scotland to become independent]?

A member of the audience picked up the point that so far,the Scottish Government has failed to propose a ‘plan B’, in the event that a satisfactory monetary union cannot beachieved. She asked the panel, if they were in the ScottishGovernment’s shoes, would they state a ‘plan B’? ProfessorMcCrone suggested that if the Scottish Government were topropose a ‘plan B’, everyone would immediately speculateupon this. He observed that the only ‘plan B’ the ScottishGovernment could feasibly have would be for a separateScottish currency. He indicated that there could be some advantages to this, but that there are also horrendous problems in relation to things such as mortgages and pensions.Dr Armstrong added that in his view, investors and privatecitizens are smarter than people think they are, and wouldlike to know that there was a ‘plan B’ in place if the currentproposals were not adding up and could not be made towork. To avoid stating a ‘plan B’ is slightly disingenuous, andonce people realised that things didn’t add up, avoiding statinga back-up plan could actually create some of the problemsthat are trying to be avoided. If people are concerned about‘plan A’, he suggested that there is a case for having a public‘plan B’. Professor Kay suggested that if he was making thisdecision on behalf of the SNP, he would keep the ‘plan B’ inthe safe so as to persuade undecided voters that nothingwould change in the event of independence. He suggestedthat he would then announce the ‘plan B’ the day after a votefor independence, observing that an independent Scotlandcould only negotiate effectively with the rest of the UK if ithad a ‘plan B’ to refer to with regard to its currency options.Ms Armstrong added that the option of an independent Scotlandadopting its own, independent currency, is probably beingkept ‘in the closet’ by the Scottish Government at the momentbecause it is viewed as too scary for voters. However, sheagreed with Dr Armstrong that voters need to know that theScottish Government has somewhere to go if a satisfactory currency union cannot be negotiated with the rest of the UK.

A member of the audience asked the panel whether, in theevent of a ‘Yes’ vote in the Referendum, there would be aflight of capital out of Scotland. Dr Armstrong respondedthat this depends on where banks are and how they are regulated, and suggested that capital flight happens if it isbelieved that there is going to be a compromise [i.e. on the

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currency option]; for example, if it appears that an independentScotland would seek a monetary union with the UK to beginwith, but would look to adopt its own currency in the long term. He observed that if an independent Scotland’scurrency arrangement was viewed to be temporary, thiscould be a disaster, because the markets would pre-empt the change and thereby force it to come about quicker thanplanned. He also indicated that interest rate risk that wouldhave to be paid would then become higher, because this isnot only an interest rate risk but also a currency risk. MsSmith asked Dr Armstrong whether it would be possible forcapital flight to occur before the Referendum. He respondedthat there could be a situation of citizens moving capital andholding their money in UK banks, but he indicated that therisk of capital flight really happens afterwards. He pointedout that the real difficulty would occur when an independent Scotland started to issue its own debt. Professor Kay arguedthat he saw the dangers [of capital flight] as being muchgreater than indicated by Dr Armstrong. He suggested that if people believed there was going to be a ‘Yes’ vote in September, the problems of capital flight would be muchwider. It is the opinion polls, which currently show a majorityin favour of retaining the Union, that are keeping the situation stable at the moment. Professor Kay observed thatthe risk is that every sophisticated individual and businesswill try to position itself to profit. The risk of Scottish independence to business is extreme instability and uncertainty affecting Scottish investment. If a ‘Yes’ vote looks possible, there would need to be clear contingencyplanning on behalf of these businesses and individuals.

Ms Smith asked the rest of the panel whether they felt thisto be a pessimistic position. Dr Armstrong responded by asking how one would speculate against an independentScotland. He suggested that one way would be to movemoney from RBS in Edinburgh to RBS in Newcastle. However, he pointed out that if RBS became a bank headquartered in London, it would not be in the interests

of the rest of the UK to refuse to recycle money back up toScotland. Dr Armstrong stated that he was sympathetic tocapital flight, but expressed surprise at the view that this wasa potential risk for an independent Scotland, acknowledgingthat the risk of this is certainly one way, i.e. from Scotland tothe rest of the UK. In response, Professor Kay made thepoint that Scotland’s currency options would affect the waymortgages and pensions are paid in Scotland, and that this is something everyone should be thinking about. He referredto the problem experienced by the Eurozone, of people taking out assets in what they thought were the stronger currency regions in the Eurozone, and matching these with liabilities in another part of the Eurozone. He observed thatthis sort of behaviour is typically a one-way bet. Dr Armstrong acknowledged this, but suggested that in the instance of mortgages, it is usual to bring in a currency conversion law. He made the point that international currency conversions are quite complex, but indicated thatthis has been done before. He suggested that in the event of an independent Scottish currency, there would be a conversion process to ensure that everyone’s mortgageswere not automatically in a different currency. He observedthat the process and the institutions required for this arevery cumbersome, and questioned the idea that this could bedone in 18 months. Professor McCrone raised the point thatif it became clear that the UK would leave the EU, this wouldbe damaging to Scotland. There is therefore a merit to Scotland staying in the EU. He suggested that this has the potential to complicate issues further. Professor Kaycommented that Scotland’s membership of the EU brings the question of the Euro as a currency option back onto theagenda.

At this point Ms Smith brought the discussion to a close dueto time constraints. The President of the RSE, Sir John Arbuthnott, thanked the audience for attending and drewtheir attention to the next event in the series, at the BritishAcademy in London on Wednesday 5 March.